Business, Government, and the World Economy

1. Business, Government, and the World Economy Investment and Saving

2. Aggregate Demand • The amount that consumers, business and Government wants to purchase. • Consumption • Investment • Government • IS/LM Model – joint determination of output and interest rates

3. Increase in Consumption • An increase in consumption may not increase aggregate demand if consumers substitute consumption for saving. • A decrease in saving decreases business investment.

4. Volatility of Investment • Investment is more volatile than output. • Investment tends to cluster in certain years, but can have a long term impact. • Cooper, Haltwinger, and Power AER 1999 – Sample of firms - 17% of investment over a 20 year span takes place in the “heaviest” year, next heaviest year less than 12%. • Investment tends to correspond with peak spending years.

5. Lags and Investment • It makes sense that investment is more volatile. • There are time lags with investment – it takes time to build new plants and equipment

6. Investment and GDPQuarterly % Change

7. Desired Capital Stock • The desired capital stock is the equilibrium level of capital spending (it maximizes profit for firms). • The level of the capital stock is determined in part by the marginal product of capital – The additional benefit of adding one more unit of capital. • However there is a lag in the investment in capital and its impact on productivity – so we are actually looking at the expected future Marginal Product of Capital

8. Finance 101 • When will a firm invest in new capital? • When the marginal product of capital exceeds the user cost of capital (think IRR>WACC) • The same type of principles apply here.

9. Marginal Product of Capital • As the capital stock increases each unit has a lower benefit. In other words there are diminishing marginal productivity of capital.

10. Marginal Product of Capital Expected Future Marginal Product of Capital Capital Stock

11. User Cost of Capital • The user cost of capital is the cost of using a unit of capital for a specified period of time • Interest cost (the real interest rate x price of capital goods) • Depreciation costs (the depreciation rate x the price of capital goods)

12. Marginal Product of Capital A Expected Future Marginal Product of Capital User Cost of Capital B Capital Stock

13. Desired Capital Stock • At A in the previous slide MPKf > uc it makes sense for the firm to add to its capital stock • At B in the previous slide MPKf < uc the firm should decrease its desired capital stock • The tax rate also impacts the relationship – The after tax MPK should be compared to the after tax uc.

14. Changes in Desired Capital Stock • The equilibrium level of capital stock will change based on: • Price of capital • Real rate of interest • Marginal productivity of capital

15. Increased MPKf causes Increased Desired Capital Stock Expected Future Marginal Product of Capital A B User Cost of Capital Capital Stock

16. Tobin’s q • The value of the stock market plays a role in consumers willingness to spend and save. • Similarly changes in the value of the stock market may impact the desire of a firm to invest (a wealth effect). • Therefore an increase in the value of the firm should cause an increase in the desire to invest.

17. Tobin’s q • The rate of investment depnds upon the ratio of the capital’s market value (V) to its replacement cost (Price of capital x capital stock)

18. q and when to Invest • If q is greater than one, it implies that the market is placing a higher value on the firms assets than the cost of replacing the assets – the firm should invest • If q is less than one the market is valuing the firm’s assets at a price less than the cost of replacing the assets – the firms should start selling off assets

19. q and Fin 101 (IRR >WACC) • The return on investment can be measured by the return on investment in new capital (basically the ROC) • The required rate of return to shareholders can provide a measure of the cost investing (ROE)

20. q and Fin 101 (IRR >WACC) • The ratio of the return on investing to the cost should be greater than 1 (the return above the cost) for the firm to invest

21. q and Fin 101 (IRR >WACC)

22. Determinants of q • The same three factors in the original model impact q • If MPKf increases future earnings increase causing Firm Value to increase and q • If the real rate of interest decreases – consumers substitute low yielding investment for higher yielding investments – increasing value and q • A decrease in purchase price of capital increases q

23. Stock Prices and Investment

24. S&P 500 and Investment • The aggregate data does not show a strong link between stock prices and investment. • Implications / Reasons • Firms do not find short term shifts in stock market values to be informative OR • Firms concentrate too much on the short term • Intangible assts are also part of investment but are not measured well. • Internal funds are major source of financing – current cash flow (not future productivity) has an impact

25. Desired Capital Stock and Investment It= Gross investment in goods and services Kt = Capital Stock at the beginning of the year Kt+1 = Capital stock end of the year d = depreciation Net invest = Gross Invest – depreciation Kt+1-Kt= It – dKt Gross Invest = Net Invest + Depreciation It = Kt+1-Kt + dKt

26. Replace K with Desired Capital Stock K* It = K*-Kt + dKt Desired Net Increase in Capital Stock Real Interest Rate Future Marginal Productivity of Capital Purchase price of Capital Tax Rates

27. Goods Market Equilibrium • Last Class we stated that in a closed economy (no trade) in other words that income and spending were always equal Y = C + I + G • Let Y be the quantity of goods and services supplied by firms • Now on the RHS Substitute desired consumption and desired investment (Cd & Id) for C and I

28. Y = Cd + Id + G Y = Quantity of goods supplied Cd + Id + G = quantity of goods demanded Unlike the GDP equation on the previous slide this will not always be in equilibrium For example, If firms produce too much output, inventories increase I this case production exceeds desired spending. The market will react to bring the goods market back to equilibrium

29. Desired Saving and Desired Investment • Starting with Y = Cd + Id + G and rearranging you get Y - Cd –G = Id Or Desired Saving = Desired Investment

30. Goods Market Equilibrium • The real interest rate will move the goods market toward equilibrium

31. Saving Decisions • Keeping everything else constant, if individuals are rewarded with a higher return on their investment, they will save more. • This implies a direct relationship between saving and the quantity of dollars supplied (As r increases s increases)

32. Graphing the Saving (Supply of Funds) Function S Real Interest Rates Level of Saving

33. Saving Decisions • Last class we how a consumer decided to spend (consume or save) • Saving Decision - An Individual’s decision to save or consume at a given level of interest rates will depend upon two main things: • Marginal Rate of Time Preference Trading current consumption for future consumption • Income and wealth effects Generally higher income – save more • A change in these variable will cause the level of saving at each level of interest rates to change.

34. Graphing the Saving (Supply of Funds) Function An increase in the level of wealth S0 S1 Real Interest Rates Level of Saving

35. Saving Decisions Summary* * Abel and Bernanke MAcroeconomics

36. Investment Decisions • The reward for saving comes from business being willing to pay interest for the funds they borrow. • Keeping everything else constant, if business is required to pay a higher level of interest rates on its borrowing, it will borrow (and invest) less. • This implies an inverse relationship between the demand for funds by business and the level of interest rates.

37. Graphing the Investment (Demand for Funds) Function Real Interest Rates I Saving / Investment

38. Determinants of Investment

39. Note: • The availability of credit plays a role in both consumption and investment (the yield spread can serve as an indicator for this) • In part reflected by expected future real interest rates • Increased borrowing may increase the user cost of capital, even if the market rate does not change • IPOs and venture capital play a key role in small firms access to funds

40. Graphing the Investment (Demand for Funds) Function An increase in the Marginal Productivity of Capital Real Interest Rates D1 D0 Saving / Investment

41. Equilibrium • The level of interest rates will then be determined by the intersection of the saving (supply of funds) and investment (demand for funds) functions. • At this intersection the demand for funds equals the supply of funds. If demand does not equal supply, the level of interest rates will adjust.

42. Graphing the Saving (Supply of Funds) Function Real Interest Rate S r I Level of Saving /Investment SI

43. Changes in Equilibrium • A change in the economy that causes a shift in either the saving or investment function will cause a change in the general level of interest rates. • For example: What if new technology increases the productivity of capital? • The demand for funds will be higher at each level of interest rates. At the original r, Investment > Savings so real interest rates will increase as firms compete to attract funds.

44. Note: • So far we have not included international trade. The equilibrium will be impacted by foreign savers and the ability for Domestic consumers to save abroad. (we will cover this soon)

45. Measuring Investment • NIPA tables • Economic Indicators • Factory Orders • Business Inventories • Capacity Utilization and Industrial Production